How to profit from the coming currency wars

Commentary: Devaluation rarely helps economy, but it can help investors

By

MatthewLynn

LONDON (MarketWatch) — Central banks around the world have tried just about everything to drag their economies out of recession. They have slashed interest rates to three-century lows, printed money in vast quantities, and recapitalized banks with soft loans.

So far, however, they haven’t had much success. Now they have one last weapon left in the armory — a currency depreciation.

All-out currency wars are now looming.

Reuters

Bank of England chief Mervyn King warns that currency wars are coming.

Whether it works remains to be seen. For investors, however, that may be less important than figuring out which countries will be successful in getting their currencies down — and which other assets will go up in value if an all-out currency war does break out.

In the immediate wake of the financial crisis of 2008 and 2009, policy makers agreed not to engage in competitive devaluations.

Beggar-my-neighbor trade polices are part of the textbook explanation for the Great Depression of the 1930s and no one wanted to repeat the mistakes of that decade.

The British managed to slip through a 25% drop in the value of sterling
GBPUSD, +0.0000%
without anyone noticing very much (a sign perhaps of the pound’s diminished importance in the world). But otherwise, currencies stayed much were they were before the crisis struck. Indeed, the main feature of the foreign-exchange markets in their last five years has been their extraordinary stability; while every other asset price went haywire, most currencies stayed where they were.

Reuters

Sweden's Finance Minister Anders Borg wants a weaker krona.

Now that is about to change. The Czech central bank said last week it would target a lower currency
USDCZK, +0.0000%
to boost its economy. Anders Borg, the Swedish finance minister, said he wanted to see a weaker krona
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to boost that country’s export industries. The Swiss have been targeting their exchange rate for a couple of years, trying to control a currency
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that has become a haven for money fleeing from the euro crisis. The new Japanese government appears intent on lowering the value of the yen
USDJPY, +0.00%
, and has been rewarded with a big bounce in the Nikkei.

There are plenty of calls for a lower euro to ease the growing recession in Europe: Jean-Claude Juncker, the chairman of the Eurogroup of finance ministers, has started describing the euro
EURUSD, +0.0000%
as “dangerously high.” And don’t be surprised if the Federal Reserve starts trying to edge the dollar
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down as well as it tries to lift growth in the United States.

Senior policy makers have started to notice. The out-going Bank of England Gov. Sir Mervyn King has already warned that currency wars are one of the main threats to economic stability. “My concern is that in 2013, what we will see is the growth of actively managed exchange rates as an alternative to the use of domestic monetary policy,” he said in a speech in New York last month.

It is debateable whether currency manipulation can ever work. While there is little question that an overvalued currency can damage an economy, there is not much evidence that devaluation improves competitiveness in anything other than the very short term. Usually it gets frittered away in higher wages and prices.

But that doesn’t mean investors can’t trade their way through a currency war. What is certainly true is that if a central bank decides to manipulate a price, then it will be affected — and getting on the right side of that trade should be profitable.

One, look to the small countries. It is very hard to move a big currency like the yen or the euro. They are very widely held, both as trading and reserve currencies. A bank will need to intervene massively in the markets, and even then success is not assured. Even if they are successful, it will provoke a reaction.

So if the Bank of Japan, for example, manages to get the yen down in value, the Europeans and Americans will react rather than see the Japanese knock out their industries. But no one worries too much about a minor currency. So if the central bank of, say, the Czech Republic or Sweden targets a lower currency they will probably be successful. Short them, and you should come out ahead.

Two, go with the trend. It is hard even for a central bank to fight reality, even if a lot of then have tried over the years. If an economy is fundamentally weak then the chances of the bank being able to get the currency down are much higher. The European Central Bank might be able to get the euro down in value if it prints enough money, because the euro zone is sliding into a deep recession anyway, which already provides a reason to sell it.

It will be harder for the Fed because, of the major economies, the U.S. looks in better shape than most. So before deciding to short a currency, look at the fundamentals, not just what the central bank wants to do. Sell off the currencies that are weak anyway, and you should be OK.

Three, switch to gold
US:GCG3
The more central banks try and manipulate the value of paper money the more investors will grow disillusioned with it. There is only one quasi-currency that nobody tries to devalue — only because they can’t — and that is gold. If central banks engage in a round of competitive devaluations, then the value of any of paper currency measured in gold will only go up.

Currency wars may well make the global economy even worse. They haven’t worked in the past, and since any country’s gain is another’s loss, they can’t do anything to improve total global output.

But if they are going to happen anyway, you need to protect yourself. None of those strategies are guaranteed to make you money, but they should at least preserve some wealth at a time when central banks are trying to push currencies down.

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